What is a DFM – 12 months on

04 March 2015

Fraser Donaldson – Insight Analyst (Investments)

What is discretionary management?

There is no doubt that the DFM market has been evolving since we last wrote an article on this topic, with many firms building and developing their propositions with the retail adviser market in mind. Add in to this the search for efficiency and cost savings, then we are beginning to see some subtle changes in the market.

Any adviser undertaking due diligence needs to be aware of these subtleties and take them into account when considering solutions for a client.

This being said, the fundamental definition of a discretionary service, as Defaqto sees the market, remains unchanged. For us, to qualify as a discretionary service, there have to be three elements:

A discretionary portfolio has to be a segregated portfolio of holdings
The firm running the money for the client has to be the one making the investment decisions
The firm running the money has to be the one undertaking the trading within the portfolio (which may include instructing a third-party platform to trade)

So, if all these boxes are ticked, in our mind this is a discretionary service. If any of these boxes are not ticked, either it is not a discretionary service or it is not a discretionary service run by the firm in question.

What are the types of DFM available?

For Star Rating and categorisation purposes, Defaqto sees three proposition types:

Bespoke. To us, this means there can be an infinite number of different portfolios. In other words, each portfolio is designed with the individual client’s needs and circumstances in mind
Managed portfolio service. To us this means that a limited range of portfolios are built by the DFM with different clients in mind. All clients selecting one of the portfolios will have exactly the same portfolio
Managed portfolio service on a platform. Similar to the above but custody is undertaken by the platform and the building blocks of the portfolio are restricted to what assets are available through the platform

In many respects this categorisation still holds good but we are seeing the emergence of some significant subtleties.

How bespoke is bespoke?

Understanding this is key to managing the expectations of the client. There is a perception that bespoke discretionary management means that every client has their own investment manager, portfolios are constructed starting with a blank sheet of paper and every holding is selected with the individual client in mind. Some discretionary firms still operate in this way.

More common nowadays is what we call the tailored portfolio. What we mean by that is that firms start with the assumption that the vast majority of investment clients fall into one of a finite number of risk profiles and attitudes to risk. They then run a number of model portfolios (typically four to eight) that relate to these profiles.

One of these model portfolios will form the basis of the client portfolio – bespoking takes place around the edges, that is client preferences and sophistication or CGT positions, for example. Many portfolios for clients that measure the same in terms of attitude to risk will look very similar if not precisely the same.

The regulators are torn on this issue. On the one hand, building a client portfolio from scratch with every holding selected for them knocks out of the park any suggestions of shoe-horning. On the other hand, the worry of two very similar clients from the same firm potentially getting very different portfolios and therefore outcomes points to the tailored approach from a consistency point of view.

One other thing to be aware of is that some firms view the word bespoke as relating to not just the investment approach but to the service provided. Clients can receive a fantastic service from the firm designed specifically for them (reporting and income frequencies, manager meetings, CGT management, banking facilities and, yes, even lunches in the oak-panelled boardroom) with a fairly standard ‘tailored’ approach to investment.

Alternatively, a client may receive a holding-by-holding portfolio construction, but perhaps with a more limited service aspect. There are all variations out there.

Having the best of both worlds may be a goal, but it's all down to what the client needs (and to some extent wants or even insists on). Every aspect of the service will cost the client, so it's a case of managing the client’s expectations and determining what they actually need to deliver the outcomes they require.

What about sugar and spice and all things nice?

When asked, almost all DFM firms will give a very long list of asset types and investment vehicles that could appear in client portfolios. Many firms are quite rightly proud of their capabilities and extent of their research resources.

However, when undertaking due diligence it is important to manage client expectations and understand what, in reality, their portfolio will look like. This is particularly important in the managed portfolio segment where clients will have no influence on the contents of a portfolio.

Firms could rule themselves out by stating they may include some of the more esoteric investments, such as derivatives, structured products and venture capital, as this may be beyond the sophistication of the client. Equally, firms could rule themselves in by these claims when the reality is that some vehicles are rarely if ever used and this could lead to client disappointment.

In the bespoke segment, the extent of investment vehicles used in portfolios could well relate to the assets under management. It would be right to question those firms that claim use of an extensive list of investment ‘building blocks’ that will accept clients with relatively low investment amounts. Not always, but the chances are, that the more the client invests the more extensive the different types of investments are utilised.

And the message?